"Thunk! I could have had a tax break!"
These days, we’d probably say that even the low-sodium variety had too much salt but in the good ol’ days, there was a vegetable drink with eight ingredients--tomato being the main ingredient—that marketed itself to the health- and weight-conscious. If you are of a certain age, you may remember the commercials from the late-70’s. A typical person or couple is chowing down on junk food when, in a sudden moment of clarity, she/he/they smack themselves on the forehead with a tin-drum sound effect and proclaim: “I could have had a V8®.” for this old commercial. For a cooler approach, there’s this Jackie Chan version. Both commercials are pretty good illustrations of 20-20 hindsight.
The day after tax season is a bit like that, if you were among the taxpayers whose refund was smaller than expected, or who (even less pleasantly) ended up owing the IRS money. And while you may be so relieved that the whole process is over that you really want/need to forget about it for the next almost-twelve months, the day-after might be a good time to consider what you can do differently next time to achieve an outcome that makes you happier. “Thunk. I could have claimed THAT.” Here’re some thoughts about what to do and nut to do to avoid regret next year.
Pay estimated taxes. More and more people these days are part of the “gig” economy, meaning that they are contractors or self-employed in respect to at least part of their income. You are one of those people if customers pay you directly and/or you receive a 1099-MISC from a company. Either way, you are “self-employed” in the eyes and rules of the IRS. This means not only that no income tax has been withheld from your payments, but also that you owe self-employment tax on that income. Self-employment tax is basically Federal Insurance Contributions Act (FICA) taxes, aka Social Security and Medicare taxes. As a self-employed person, you pay both the employer and the employee shares of this tax--although you get to deduct half of it further down your return. For example, if you have $10,000 in contract or self-employment income (after deducting applicable expenses) and you are in a marginal 20% tax bracket, then not only do you owe the IRS $2,000 in income tax, but you also owe them an additional $1,413 ($10,000*.9235*15.3%) in self-employment tax. For a handy calculator check here: You are supposed to pay both taxes quarter by quarter to the IRS as estimated tax payments. If you don’t, not only will you end up with a big bill by April 15, but you may also owe an underpayment penalty if you overlook this.
Know your retirement account rules. Your 401(k), 403(b), IRA and other qualified money is yours to withdraw at any time after your age 59-½. Unless any of these accounts are “Roth”, the money that you put into them is pre-tax money, and the growth of the money has accumulated tax-free. This means that anything you withdraw is taxable at your marginal income tax rate. It may be best to request that the plan holder withhold at least 15% for Federal taxes, so you don’t end up with a big bill at tax time. Note that retirement-account withdrawals are not taxed by some states. For a full picture, look up your state here. In most cases, if you withdraw any qualified retirement money prior to age 59-½, you will also pay a 10% early withdrawal penalty. You can avoid the penalty if you withdraw from your IRA to cover higher-education expenses for either yourself, your spouse or your children, or to pay medical expenses in excess of 10% of your AGI. You also use IRA funds penalty-free to pay health insurance premiums if you are unemployed. You can take up to $10,000 from your IRA penalty-free for a first-time home purchase. You can also take money out penalty-free for any reason if you are totally and permanently disabled. Rules are much stricter for 401(k) and other employer plans, but you can withdraw without a penalty for medical expenses over 10% of AGI. For the complete rules, look here.
Take care if divorced. Even the most civil of divorces makes things more complicated at tax season, especially if there are children as a result of the marriage. Each divorce decree attempts to allocate custody of children in the way that makes the most sense—ideally for both the children and for each of the parents. However, you should know that IRS regulations trump anything that might be written in your divorce decree, and the IRS regs are very specific. For IRS purposes, only one parent can claim a child in any given tax year, regardless of whether each parent contributed equally to the child’s maintenance and upbringing for that year. Typically, the parent with whom the child lives for a greater portion of the year—even if greater by only one night—is the official custodial parent and gets to claim the child as well as certain tax circumstances that come along with claiming the child, such as Head of Household filing status with its larger standard deduction, the Earned Income Tax Credit, the Child Tax Credit, and the Additional Child Tax Credit. The list used to include personal exemptions, but those no longer exist under the Tax Cuts and Jobs Act. If the child lived with each parent for the same number of nights, then the parent with the highest income claims the child. The custodial parent may release the Child Tax Credit to the non-custodial parent by completing IRS form 8332. Only the custodial parent may claim Head of Household and Earned Income Tax Credits, requiring a qualifying child.
Realize who is a qualifying dependent. A child has to meet certain requirements to be your qualifying child. The person must be your biological or legally adopted child, or be a child who is officially placed with you for foster care. It cannot be a child who is staying with you through informal care-giving. The child can also be a descendent of one of these aforementioned legal children or be your sibling, half-sibling, step-sibling or a descendent of any one of them. Your cousin is not a qualifying child, even if living with you. The legally claimed child must also live with you under the same roof in the United States for more than ½ the year and must provide less than ½ of her/his own support. The child must also be under age 19 at the end of the tax year, under age 24 if a full-time student, or permanently and totally disabled at any age. The child cannot file a joint return. To be eligible for the child tax credit, the child must be under 17 and be a US citizen. For more details, see here. For a person to be a qualifying relative, s/he must NOT be a qualifying child of anyone, must be a resident of the taxpayer’s household for the full year, and must have a gross income less than $4,150 (non-taxable Social Security benefits do not count). The taxpayer must pay more than half the person’s support. For the full decision process, see here.
Knowing how much and what kind of income you will have, as well as whom you may consider as a dependent, will help you have a better idea of how much tax you will be assessed over the year. You can then look at your withholding. If last year’s tax refund was too low, you can increase withholding if you do not want to owe the IRS again next year, or if you want the enforced savings of a refund. Next time, you can have a better tax return as well as a V8®.